BACKGROUND
This post briefly describes how interest rates affects life and general insurers and plausible models to predict future short term rates or spot rates movements. Interest rates has minimal impact on General Insurers but nevertheless is discussed for comparison purposes.
INDUSTRY RISKS
Common & key risks identified in the two industry.
Life Insurer's risks
1. Liabilities pricing Risks (Pricing of Best Estimates)
2. Asset Value Risks (Change in Asset Valuations)
3. AL Mismatch Risks
4. External Risks
General Insurer's risks
1. Operational Risks
2. Financial Risks (Investment yields)
3. Strategy Risks (Business decisions)
4. External Risks (Catastrophe)
MODEL CHARACTERISTICS
Characteristics of models appropriate for Interest Rate Modeling
Discrete Models
Used in scenarios where interest rates change at specific interval (Monthly/ quarterly/yearly
Continuous Models
Used in scenarios where interest rates change continuously and smoothly)
Models with Single Factor.
One term structure for each type interest rates to be tested. Examples are:-
1. Short term rates used for Discrete models
2. Spot rates (instanteneous short term rate) used for Continuous model.
Models with Multiple Factors.
Variety of alternative for additional factors. Examples are:-
1. Short term & long term rates
2. Short term & inflation rates
General Equilibrium Model
Models term structure behaviours over time.
1. Utilizes economic assumptions (supply & demand) , investor’s expectations and setting of short term interest rate factors.
2. Output will be future term structure of interest rates.
3. Captures time series variations and movements of interest rate.
INDUSTRY CONDITIONS & REQUIREMENTS
Business environments for the two insurers and suitable models for interest rates prediction.
Life Insurer
1.Models require embedded options. (Policyholder's returns)
2. Utilizes Interest rate & equity models
3. Long term policies & window.
4. Two factor general equilibrium models would be suitable and focus on Interest rate as key variables against embedded options.
General Insurer
1. Focus on Catastrophe modeling
2. Less emphasis of long term horizon in credit risks (O/S premiums or defaulting reinsurers)
3. Holistic View on Financial Conditions
4. Focus on long term projections of claims and less on interest rates.
5. One factor general equilibrium models will do for ERM & RBC purposes.
VIEWS
Historical info such as volatility, shape of terms structure and mean reversion speed is crucial in Identifying the types of interest fluctuation prior to applying the correct model.
Brief Information on how Banks price interest Rates with models such as Arbitrage-Free Models will be posted subsequently.
